Seeking Alpha
Research analyst, macro, deep value
Profile| Send Message|
( followers)  

With the Fed's latest round of QE and renewed expectations for inflation driving asset prices higher it seems necessary to delve into exactly what the Fed hopes will happen this time around and what has happened on previous QEs. We will start this discussion with a little refresher course on how the Fed's policy is supposed to work to expand money supply.

Fractional banking

Despite the popular perception that the Federal Reserve prints money that is not really the case. What the Fed does do is use various tools to expand and contract money supply to steer certain economic metrics in the desired direction. In a recession or a period of slow growth the Fed wants to expand the money supply - the idea being that with more money in the economy more will be spent.

Increased spending creates an increase in demand for goods and services requiring more employees to meet the demand. As new employees are hired they get a paycheck and start spending for goods and services and in so doing increase the demand further. This process continues - in theory at least - until full employment is achieved.

So how then, does the Fed increase the money supply if it doesn't print money? It does that by changing monetary policy in a way that results in banks in the private sector lending more money.

Banks operate on what is called a fractional reserve arrangement. What that means is that when a bank takes in deposits a certain percentage of those deposits must be retained in cash. These reserve funds cannot be used to fund loans or to buy securities. In this case cash means cash.

Although the percentage of reserve cash the bank is required to hold varies based on the size of the bank and also on the nature of the deposit, we are going to simplify the process here and just use 10% as the reserve requirement which is, at the present time, at the high end of the scale and applies to large banks.

The best way to illustrate this process is to use a very simple balance sheet presentation showing shifts in a bank's balance sheet as certain things occur. We will start by setting up a fictitious bank with a capital contribution of $200,000. We will assume that ½ of the bank's capital is invested in allowable securities and the remainder is held in cash.

The balance sheet below shows the values for all accounts at the time of formation in the column for January. The only thing reflected for January is the $200,000 capital that the bank owners put up at inception. Double entry accounting requires that we reflect the cash and securities as assets (a debit entry) and the offset entry as capital contribution (a credit entry).

(click to enlarge)

In February we open our doors and take in a deposit for $100,000. That is reflected as an asset in the cash account and a corresponding entry for the liability in the deposits account. You will also note that we placed $10,000 of the cash into the bank's reserve account. That is the 10% reserve requirement set by the Fed. After deducting for the 10% reserve we are left with $190,000 in our primary cash account. These are funds we can loan out.

Here is where we start to see how private sector banks are able to create money. In March we make a loan for $100,000. The entry we make is to set the loan up as an asset and since we now need to fund the loan we make an entry to cash to show that we deposited the money in the borrower's bank account at our bank.

So what happened when we made that loan? The answer is that through a bookkeeping entry we just created another $100,000 in deposits. We have increased the money supply by $100,000 with that loan.

We now have $190,000 in cash we can lend out so we repeat the process in April with another loan for $100,000. Our bookkeeping entry is to post $100,000 to our deposits account, $100,000 to our loans account and $10,000 to our reserves account.

At this point we have met our cash reserve requirement of 10% of deposits and we still have $170,000 in our cash account since the loan proceeds went into the borrower's checking account at our bank. We are in full compliance with our cash reserve requirement and we still have $170,000 in cash so we can make another loan for $100,000 next month.

We repeat this process every month through June and at the end of June we still have $150,000 in our cash account but we have expanded customer deposits to $500,000. Keep in mind we did that on the basis of a single $100,000 deposit in February. All the other deposits were simply bookkeeping entries that increased the bank's cash account (an asset/debit entry) and the bank's deposit account (a liability/credit entry).

Keep in mind this is a very simplistic example. Furthermore it assumes that all the loan proceeds remain in our bank, which is not what happens in the real world. In the real world the borrower spends the loan proceeds shrinking the deposit balance at our bank. In our fictitious world we are going to assume that we are the only bank in the world so whoever the borrower spent the money with is going to have to put it right back into our bank leaving the amount in our deposit account unchanged.

Again, that is not the real world but that new money we created when we made the loans will end up in a bank somewhere and that is what the Fed looks at - total money supply. If money supply is increasing when we make a loan then the Fed is happy.

So how does QE impact this process?

To explain how QE works we are going to have to move down the line with our lending. The balance sheet below reflects the 1st half of our second year. As we continue to make loans and increase deposits we eventually run out of money in our cash account to make another $100,000 loan. By December our cash that is available for new loans has finally dipped below $100,000.

Over the course of the 1st year our deposit balance has grown to $1,100,000. Keep in mind that the only outside money here is the initial $100,000 deposit. We have effectively pyramided that single deposit into $1,100,000 but we have depleted our cash down to just $90,000. The reason for this is that the amount of each new loan that has to move to the reserve account - $10,000 a month - has gradually brought our cash balance down to a point where we can't fund a loan for $100,000.

We have reached our limit on loans and can no longer impact money supply. So here is where the Fed enters the picture. The Fed tells us that it is buying $100,000 of our securities for cash. Now we will look at one more balance sheet for the 1st half of our second year to see what the impact of that Fed action - or QE - actually does for us.

In January the Fed buys our $100,000 in securities with cash. The entry to our books is a credit to the securities account for $100,000 and a debit to our cash account for $100,000.

(click to enlarge)

Now we have cash to lend again so we start the process over and each month we lend $100,000. At the end of June we have deposits totaling $1,700,000. Of that total only $100,000 represents money that flowed into the bank from an outside source. The rest of the deposit balance was created internally within the bank through bookkeeping entries.

So, with the Fed's move to add liquidity thorough QE by buying our securities for cash we continued to loan and expand the money supply - in this instance by an additional $600,000 based on the Fed's purchase of just $100,000 of our securities.

Again, this is a very simplistic example designed to demonstrate the process that the Fed uses to expand the money supply. As you can see the Fed has very little to do with the process. It did not just give us a pile of money as many believe and it did not crank up its electronic printing press. It did nothing more than buy $100,000 of our securities for $100,000 cash. It was the loans that our little bank made that increased the cash deposits.

So can QE ultimately fail?

To answer that question we need to consider what is required. We need two things - a bank that is willing to make loans and qualified borrowers that are willing to borrow money.

Banks

We will discuss both. Let's start with the banks. The truth is banks are not that motivated to lend for two reasons. The first reason is a prudent degree of fear that was brought on during the bank crisis. We were just a heartbeat away from a complete systemic collapse of the banking system and bankers remain justifiably fearful.

We have taken steps to deal with these problems. Today our banking system is reasonably healthy but the aftershock of the near miss on a systemic collapse of the banking system in America is still fresh in the minds of everyone.

Banks have moved from lenient credit requirements to very tight strict credit requirements. Banks just don't want to take risks today. Another thing that is keeping the banks on the sideline is the flat yield curve that does not allow banks to make a decent return on loans.

The 3-6-3 rule is intended to be humorous but only to a degree. The rule goes like this. The banks will borrow at 3%, lend it at 6% and be on the golf course by 3:00 PM. With the 5-year treasuries yielding .67% and the 10-year yielding 1.76% at this time the 3% spread is not there.

Borrowers

Even if the banks were eager to lend borrowers - at least those the banks would want to lend to - are not at all eager to take on debt. The same malady that inflicts the bankers is also inflicting qualified borrowers.

It is no wonder that people feel this way. It is no secret that unemployment levels are close to depression levels and that monetary and fiscal policy has not improved the situation. It is also common knowledge that the housing crisis took a huge toll on America. Most qualified borrowers are aware of the pending "fiscal cliff" and our dysfunctional government.

There are a lot of things to be discouraged and fearful about and people who are fearful don't borrow - they save. That is exactly what we have seen since the end of the recession - a significant reduction in debt and an increase in savings.

So back to the question - can QE fail? The answer is that not only can it fail but it has failed. With banks not willing to take risks and borrowers not willing to take risks the Fed ends up with a busted policy.

Can we say that our government leaders and our central bankers are worried? Well, we can at least say the central bankers are worried. The mechanics of monetary policy tend to go over the heads of a good number of our leaders in Congress and it is doubtful that our President fully understands how truly ineffective monetary and fiscal policy has been. They certainly see the symptoms but explaining why the policies have failed tends to elude most people.

Why QE3 was the wrong thing to do

Ben Bernanke did the right thing with QE1. We were in a recession and deflation was starting to rear its ugly head. The chart below shows how serious the situation was in 2009. QE1 managed to turn inflation back to the positive. The disturbing thing about this chart though is that after each successive QE the inflation rate starts to fall again.

That is simply not what most people think is happening. If you ask most people - and that includes a majority of traders and many analysts - they don't know what this particular metric of economic health is really showing. As an avid student of macro economics I will tell you that it is showing you that our economy is shrinking as debt continues to be paid down and savings are increasing. The unemployment situation is also a very critical concern.

A deflationary spiral feeds on itself shrinking the economy further and further. While we are wanting it to expand to accommodate the unemployed and provide them with jobs what we get is the opposite - an ever increasing unemployment rate as companies strive to stay alive by cutting costs. It is the worst of all possible scenarios.

Another chart that confirms the ineffectiveness of Fed policy is the M2 money supply chart less the saving component of M2. As we know from the discussion above it is only with an expanding money supply that we are able to grow the economy and that increase in money supply is the result of net new loans being created. They are not being created and the chart below proves that point.

These two charts paint a pretty bleak picture. Fed policy is a failed policy and we have made no headway at all in the last 4 years. We have tried though and in the end these efforts are going to end up sinking us back into a recession in 2013. The chart below sets up the first problem - our debt-to-GDP ratio.

This is a serious problem in that debt has a carrying cost. We must pay the interest on this debt. The other problem is that debt is a constant in our economy. Our government never pays the debt off. It just keeps on getting bigger and bigger. We talk about the Bernie Madoff ponzi scheme - well the federal government is far and away the biggest ponzi schemer of all time. When our debt obligations come due we simply issue new bonds and use the proceeds to pay the old ones. At record debt levels the cost on these debts could become much higher.

The 10-year bond today is only 1.76%. but that is certainly going to go up if we don't attack the problem with aggressive measures to reduce deficit spending. Let's look at deficit spending.

These two charts set up the "fiscal cliff" issue - not exactly a pretty picture here either. As we have worked through this macro analysis we have shown how QE is supposed to work and with the money supply and inflation charts shown that it has not worked. At this point we now must deal with the deficit spending.

Debt to GDP is already at crisis levels. How do we solve the problem? We hear politicians, analysts and economists say we have got to come up with a plan. OK, what is the plan? If we don't tackle the deficit with spending cuts and tax hikes the problem will simply get worse and worse until there is no turning back. Greece is an example of where we are headed.

If we do go ahead and attack the deficit with tax hikes and spending cuts the problem still gets worse. Here is why - we will suck about $600 billion out of the economy that would otherwise go toward GDP. That is about 3% of GDP and it is what we can expect GDP to contract to by going ahead with the tax hikes and spending cuts.

The reason the politicians, analysts and economists don't offer a viable plan is that there is no viable plan. No matter what we do the situation is going to get worse before it gets better. Bernanke's QE3 was a terrible decision. All QE3 has done is create an equity bubble. We are at a crossroads and neither road leads us to where we want to go.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am short a number of tech stocks, financial stocks, crude oil and gold.

Source: Understanding Fractional Banking - Why QE Has Failed